Very High Bar for QE3

My first thoughts: The FOMC statement was consistent with my expectations, while Federal Reserve Ben Bernanke sounded slightly more hawkish than I anticipated. The latter confirms the view I took two weeks ago – near term inflation gains were not sufficient to justify altering the current policy stance, but would derail any additional increases to the balance sheet beyond June.

The FOMC statement itself was largely straightforward. Arguably a bit of a downgrade of the economy (as CR notes, the “firmer footing” language has disappeared) and a little more talk about inflation. The new economic projections reflected these alterations, with growth forecasts brought down to pretty much the same range when the Fed initiated QE2, while near-term headline inflation forecasts are higher.

The initial phase of Bernanke’s press conference was also in line with my expectations. He noted that the expectations for trend growth and the natural rate of unemployment were beyond the control of the Fed, while inflation was directly determined by monetary policy. He explained the reasoning for a positive rate of inflation, explicitly pointing to the concern about deflation, defined as falling wages and prices. This was, I believe, the last we heard about wages.

In response to the Q&A portion, he said the impending weak Q1 growth numbers are the result of transitory factors (defense spending, exports, weather), and “possibly less momentum.” The latter phrase was a bit disconcerting and should suggest a predilection toward additional asset purchases beyond June, but apparently the FOMC intends to focus on the transitory nature of the numbers. See again my earlier piece. When questioned about the timing of any exit, Bernanke explained the relevant factors, including the sustainability of the recovery, the strength of the labor market, the direction of inflation, and resource slack. Not surprisingly, he gave no timeline to tightening.

Regarding the end of QE2, he reiterated the “stock” view of the balance sheet. Essentially, the pace of accumulation is less important than the size of the balance sheet, and there were no plans to shrink assets. Indeed, he suggested the first step toward tightening would be to stop reinvesting assets as they mature or are redeemed. I thought he handled the Dollar questions well – throwing it back in the lap of Treasury Secretary Timothy Geithner and claiming, rightly in my opinion, that the best thing for the Dollar over time is that the Fed pursues policies that satisfy its dual mandate.

The most interesting comments came in response to questions about whether the Fed should do more to lower unemployment and if QE2 is effective, shouldn’t the program continue? Here was a more hawkish Bernanke. As I noted earlier, growth forecasts returned to the pre-QE2 range, which should be a red flag. Unemployment remains high, with only moderate job creation. Core-inflation remains low, while the impulse from commodity prices on headline inflation is expected to be temporary. Finally, he claims that QE2 was in fact effective. So why not do more? Because the Fed needs “to pay attention to both sides of the mandate” and the “tradeoffs are less attractive.” Much talk by Bernanke at this point about inflation expectations, and the importance of maintaining those expectations, and not much (none, I think), about the issue (or non-issue) of wage inflation.

Apparently the threat of headline deflation off the table, Bernanke is not inclined to pursue sustained easing despite low core inflation and high unemployment. Again, I am not entirely surprised, except that Bernanke appear to suggest we are much closer to an inflation tipping point than I would expect. He could have tempered these comments with a more forceful discussion of labor costs, but did not. It seems clear these comments were intended to calm the non-existent bond market vigilantes, but is it consistent with the outlook? Arguably, no. For what it’s worth, I think Bernanke appeared most uncomfortable during this portion of the conference.

Bottom Line: When I look at the revisions to the Fed’s outlook and listen to Bernanke, I get the sense that the basic Fed policy is summarized as follows: “The economic situation continues to fall short of that consistent with the dual mandate, we have the tools to address that deviation, but will take no additional action because some people in the Middle East are seeking democracy.”